National Institute of Economic and Social Research

Monday, 2 April 2012

The European Commission asks the wrong people the wrong questions. No wonder it gets the wrong answers

Last week representatives of the European Commission came to see me and colleagues at NIESR to discuss the economic prospects for the UK. We had a sensible discussion, during which time I expressed my view that slowing fiscal consolidation would boost growth and employment without posing any significant risk to fiscal credibility, and that in this respect the Budget was a missed opportunity. When I made this point, the head of the delegation said that they had seen the ratings agency Fitch that morning, who took a different view.

At this point, I'm afraid, I slightly lost my cool and said in no uncertain terms both what I thought about the ratings agencies and what I thought of the Commission for spending time listening to them and, presumably, taking account of their views in their final report. I subsequently emailed the Commission representatives to set out my thoughts in more considered fashion. Here they are (only slightly edited to put them in context):

"Thanks for coming in to see us yesterday. I hope you found it useful.

Just for the record, I would like to make it clear that I was absolutely serious in what I said in our discussion about Fitch. It is my view that for you to meet with Fitch (or other rating agencies) as part of your information gathering for your forecast and policy recommendations is not simply a waste of time, but positively irresponsible and damaging.

These agencies have repeatedly been proved wrong; they have flawed and frequently conflicted business models; and their ratings have no predictive power. All this is well established. Moreover, when it comes to assessing sovereign debt "credit risk" they - and I mean this quite literally - do not know what they are talking about. By that, I mean they quite simply don't understand what they themselves are saying. See my blog here for an explanation.

It is simply not, I am afraid, a justification for you to say that you listen to a "diverse range of views". You have limited time, and you have to be selective. Who you choose to talk to, and listen to, is in itself an economic and political (small p) choice - this is obvious.

There are plenty of very serious and competent economists here in London who you will not have time to talk to; some of them broadly agree with me, some don't. Why, for example, are you not seeing John Van Reenen, Director of the Centre for Economic Performance at the LSE, and co-Chair of the LSE Growth Commission? John wrote an excellent article on the Budget here. There's more sense in every paragraph here than in everything Fitch, Moody's and Standards and Poors have said over the past year about the UK.

Similarly, why not talk to Ian Mulheirn (Social Market Foundation, ex-HMT), who wrote this FT piece. I don't entirely agree with it, but it's a sensible contribution to the debate. And if you want somebody who disagrees with me about the case for fiscal loosening now, talk to Roger Bootle (Capital Economics), who is always thoughtful and well-informed on UK macro issues, even if I disagree with him on this specific point.

These are serious people with serious things to say (and I could name half a dozen more). By choosing to spend your time instead with people who are both structurally biased and serially incompetent, and whose track record clearly shows their irrelevance (at best), you both bias your report and you reduce its quality. That is bad for the Commission as well as the broader policy debate.

As you will have noticed, I don't mince my words. I am genuinely trying to help you improve the quality of your analysis, and I hope you take it in that spirit."

Now I don't think it really matters that much what the European Commission says about the UK economy one way or the other. But that is unfortunately not true of the eurozone, where the Commission, especially Commissioner Rehn, the ultimate boss of the people I met, has got pretty much every single major economic policy decision of the last two years wrong.

Their single-minded focus on austerity in the face of recession - in Greece, Ireland, Portugal, and nowSpain - has made a bad situation much, much worse. Again, there are plenty of excellent economists in the UK pointing this out, from Simon Wren-Lewis here to Jason Rave here. But the Commission seems neither to talk to or listen to them either. If they insist on asking the wrong questions, and listening to the wrong people, there is little hope that they will get it right in future.

6 comments:

Is the concern about Keynsian economics the wrong way round? Ie instead of worries about the "make meChaste but not yet" side, should we be worrying about whether govts will actually loosen in bad times?

By way of example, Europe (including UK). By way of analogy, skiing. Your instructor says " lean forward and put your weight on the lower ski." But that's counter-intuitive, and requires nerve, so you chicken out, and lean back. Result, you go downhill like a rocket, taking innocent people with you.

A bit like following what prof Krugman calls very sensible people. You end up doing something daft. Is the difficult part with Keynsian policies not re-trenching in good times but spending in bad times? However obvious to you, it's counter-intuitive to the rest of us?

I fully understand the argument that what is going on in Greece, Portugal and so on is something of a train wreck, and poses a significant political risk to the entire european "project". But the problem here is that the Commission is trapped, institutionally. They simply cannot easily come out and declare that Greece has no future inside the eurozone, whether they believe it or not.

Partly because this would create a total firestorm of political recriminations, but also this would essentially force Greece out of the eurzone, probably lead to widening premiums on spanish, portuguese and italian debt on speculation that they are next, and that would be something of a self fulfilling prophecy, finishing the euro off in short time.

Maybe that would be the best option in the long run, but is it really a decision for the Commission to take? The political ramifications are huge.

They have chosen the less explosive option (in the short run, anyhow) - to try desperately to hold the eurozone together. Which leaves them with a problem = how ? What should they do? What to do to solve the chronic budgetary and current account problem in Greece? Tthere isn't much option but to lend them money - Greece has no access to the capital market - but nobody is going to pour money into a black hole - and it is a very widespread feeling that Greece is exactly that.

Which is why they - or rather the member states who actually stump up the cash - have gone down the route of lending money, but insisting on heavy influence in Greece's domestic policy, to try to implement reforms that Greece should have done itself ten years ago, in a rather desperate attempt to generate some kind of tangible improvement in competitiveness via a form of competitive deflation.

Now, I can see all sorts of reasons why this may not work. And I can see all sorts of "micro" issues about programme design and so on, and that it is far more important to establish fiscal credibility in the medium run than to achieve short run cuts ... there are all sorts of practical/tactical issues there where one could discuss whether the programme makes sense. But there is a background issue, which is that Greece simply HAS no credibility. Nobody believes the line that what is not done today, will be done tomorrow.

But the bottom line is that the Commission is trying to follow a party line, because the political consequences of doing otherwise are too unpalatable. In essence they are leaving it to Greece or other MS to reach the conclusion that it is not workable. This may not be bold, but it seems to me to be pretty understandable.

1. They are there to assess how risky debt is. It makes sense for this job to be outsourced to a few third parties rather than everyone replicating the work in-house (especially for lower risk debt like UK gilts). As such they are important - they are a bit like an informal credit committee for the debt markets.

2. Your claim that "their ratings have no predictive power" is simply wrong. AAAs are less likely to default than BBBs, BBBs less likely than BBs and so on down the rating scale.

3. That said, they are just a group of people with conflicts of interest, limited knowledge of the future, like you or I. Yes, they get things wrong, but so does everyone who makes public predictions in the financial markets.

4. Have they got things wrong enough to lose all credibility? In some structured finance (especially CDOs) the answer is clearly yes. The problem was they completely miscalculated (ignored) the correlation between assets. For corporate and government debt, their record is respectable.

I think you disagree with the message they are delivering: (i) taking on more debt makes the debt more risky and (ii) too large a public sector means slower growth which means, again, more risk for the debt.

This is, however, the general view of the debt markets (point (i) is arguably more debatable than point (ii) where the view is pretty universal). As these are the people who ultimately buy the debt it is worth hearing their views before proceeding with a plan.